Credit: Shutterstock photoIf holiday spending has boosted your credit card balances, leaving you struggling to cover those and your other obligations, it may be time to create a strategic plan to pay off your debt as quickly as possible.
Assuming your debt derives from multiple sources — a number of credit cards, perhaps, along with various loans — here are two great ways to organize it and begin to pay it down. One is called stacking, and the other is frothily titled the snowball method. Here’s how these two debt repayment methods, er, stack up and which may best suit your style and financial situation.
Stacking Up Your Debts
With the stacking method, you organize your debts in the order of the interest rate you’re incurring on each of them, from highest to lowest. The dollar amount doesn't matter, only the interest rate. Your list might look something like this:
- MasterCard: $2,000 19% interest
- Car Loan: $13,000 8% interest
- Student Loan: $7,000 4% interest
You use every dollar you can to pay off as much as you can on the MasterCard each month while paying just the minimum payments on the other debts. When the MasterCard balance is paid off, you take the money you were paying monthly towards it and use that amount, along with every other dollar you can spare, to pay off the car loan. You continue doing the same down the list until all of the debts are paid.
The big benefit of stacking is that, by paying off the debt with the highest interest first, you save on interest charges, especially when high-interest debt sources like credit cards are involved. Take a scenario where you were paying $100 per month on that MasterCard balance; that schedule would require 25 months to pay it off and you’d pay a total of $424 in interest.
Then consider, say, redirecting to the MasterCard a $100 extra payment you’re making monthly on your student loan to pay it off more quickly. With that additional $100 added to the mix, you’d pay off the card debt in just eleven months, an advance of more than a year, and pay only $195 in interest, a savings of more than $200 in interest.
The downside to using the stacking method is the time it can take to see progress. Particularly if your highest-interest debts are also ones with high dollar amounts, the process may make you feel like you aren't getting anywhere, even after several months of payments.
Snowballing Your Obligations
The snowball method inverts the priorities you use when stacking your debt. You organize your obligations by their dollar amount, lowest to highest, without regard for their respective interest rates. So, using the example above, the same debts above would be re-ordered in this way:
- MasterCard: $2,000 19% interest
- Student Loan: $7,000 4% interest
- Car Loan: $13,000 8% interest
The repayment process is the same as we described above. All of your extra money goes to the first debt on the list while you pay the minimum on the others. As each debt is paid off, you use the money you devoted to it each month and apply it to the next obligation on the list.
The pros and cons of the snowball method are also inverted compared with stacking your debt. You bask in the feeling of accomplishment, which may provide useful motivation to stick with the program that you won’t get from the stacking approach. Overall, however, you’ll wind up paying more in interest charges than if you’d used the stacking method.
Which Method Makes The Most Sense?
By financial considerations alone, the stacking method wins without question. Paying down the highest interest rate debt first allows you to save money in overall interest payments.
But snowballing your multiple obligations can create a feeling of satisfaction that powers you along in your plan. It’s especially alluring if you have a number of smaller debts that have been hanging around for a long time, and that you can plow through relatively quickly if you opt for snowballing.
You can also switch up your approach, and shouldn’t feel married to one method or the other. You could, for example, start with the stacking method to save interest on a loan with an especially high rate. If it starts to feel like you aren't making any progress, you can switch over to the snowball method. In the end, whichever method will work best for you is ideal, almost in spite of the numbers.
A few caveats to either approach, though. In your enthusiasm to reallocate payments, don’t let any obligation slide to the point where you miss a payment entirely and incur penalties; those will only add to your debt, and perhaps darken your mood, too. Also, try to limit discretionary spending while the plan is in progress — perhaps that that new 4K TV can wait? And if you must add to your debt, do so to the credit card or other vehicle with the lowest interest rate.
The article Tackling Your Debt: Stack or Snowball It? originally appeared on ValuePenguin.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
